NISM Certifications · NISM-Series-X-A: Investment Adviser (Level 1) · Introduction to Modern Portfolio Theory
Rahul holds a stock with an expected return of 11% where CAPM gives a required return of 13%. Based on the Security Market Line, what does this indicate?
The stock is overvalued and plots below the Security Market Line. Its expected return of 11% is lower than the 13% required for its systematic risk, giving a negative alpha of 2%, so investors are not adequately compensated.
- AThe stock is undervalued and plots above the SML
- BThe stock is overvalued and plots below the SMLCorrect
- CThe stock is fairly priced and plots on the SML
- DThe stock has a negative beta
Explanation
Alpha = expected return minus required return = 11% - 13% = -2%. A negative alpha means the stock plots below the SML, offering less return than its risk warrants, so it is overvalued. Undervalued stocks plot above the line.
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